Know the rules when you inherit an IRA
Summary:
There are no early withdrawal penalties on inherited retirement accounts.
Inherited Traditional accounts are taxable; Inherited Roth accounts are not.
Most beneficiaries will need to withdraw all the funds within 10 years after the death of the account owner.
Spouses and certain other beneficiaries are eligible for preferential treatment.
If you are inheriting a retirement account from your parent, we’ve created a flowchart to help you understand the distribution rules. Click here to see it!
When you inherit a retirement account from a friend or loved one, it’s important to know the tax implications of withdrawing from these accounts, and to meet the minimum withdrawal requirements imposed by the IRS.
Taxes and penalties on inherited retirement accounts
Inherited retirement accounts are taxed in the same manner as before they were inherited.
Traditional pre-tax IRAs, 401(k)s, etc. are taxed as ordinary income when withdrawn. Inherited Roth accounts are not taxed, since the tax was paid on money contributed into the account.
Depending on the size of the inherited account, withdrawing a significant portion of the account can send you into a higher tax bracket. To mitigate this, it’s commonly recommended that you withdraw a small amount of the account every year to spread the tax hit over time.
Inherited accounts do not have early withdrawal penalties. If you inherit a retirement account, even if you are not “retirement age” (59 ½), you can withdraw the money penalty-free.
Eligible beneficiaries
Certain beneficiaries are eligible for preferential treatment when inheriting IRAs. These are:
*Decedent is a legal term for the person who died.
Surviving spouses
Disabled or chronically ill persons
Persons less than 10 years younger than the decedent* (i.e. someone close in age or older, such as a sibling or a parent)
Minor children of the decedent
Some see-through trusts benefiting persons above
Special rules for spouses
Surviving spouses who are the sole beneficiary have the most options available when inheriting retirement accounts.
The most common strategy is the spousal rollover, in which you roll the money into your own IRA. This strategy works because the Required Minimum Distributions (RMD) are smaller for an account you own than an account you inherit. This also works well when your deceased spouse is significantly older than you are; rolling his funds into your account will let you delay RMD longer.
You don’t have to complete the spousal rollover right away, and the optimal timing varies based on several factors.
The 10-year rule
If you inherit an IRA and you are not an eligible beneficiary (defined above), you will need to withdraw all funds from the inherited account by December 31st of the year containing the 10th anniversary of the decedent’s death. For example, if you inherit an IRA from your father who died March 1st, 2024, you will have to withdraw all funds from the IRA by December 31st, 2034.
In addition to the 10-year rule, you may have to make Required Minimum Distributions from the inherited account, which is discussed below.
Required minimum distributions
There is no rule dictating the maximum you can distribute from an inherited IRA, but there are rules for the minimum you must withdraw each year. The minimum distribution is different depending on your relationship to the decedent.
Adult chlidren
The current RMD beginning age is 73. You must take your first RMD before April 1st following the year you turn 73.
Most adult children would be a non-eligible beneficiary and subject to the 10-year rule (both terms defined above). If the decedent was already taking RMDs (see orange text to the right), the adult child beneficiary must continue RMDs based on their own life expectancy, in addition to ultimately satisfying the 10-year rule. If the decedent had not yet reached RMD age, the beneficiary does not need to take RMDs but is subject to the 10-year rule.
If you have questions about an account you inherited from your parents, contact us for a free consultation.
Eligible beneficiary
If you are an eligible beneficiary (defined above), you can do what’s known as a “stretch” RMD. A stretch RMD allows you to make distributions from your inherited IRA over your lifetime. Depending on the size of the account, it may not be a huge distribution – in certain cases you may need or want to take more than the minimum – but many people enjoy the small annual “gift” from a deceased loved one.
Surviving spouse
Surviving spouses are considered eligible beneficiaries, and if you are the sole beneficiary, you have access to other spouse-specific options (described above).
Summary
The rules are generally simple: no penalties, yes taxes, 10-year rule, and maybe RMDs. But, as with all things IRS, the details are very important to get right.
If you have inherited or expect to inherit an IRA, it’s generally a good idea to contact a tax or retirement professional. Most professionals will offer a free consultation where you can ask questions specific to your situation.
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